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Monday, December 24, 2018

Plantation sector - Tough times ahead

Investment Highlights

Underweight. We recommend to SELL Kuala Lumpur Kepong (KLK), Genting Plantations (GenP) and Sime Darby Plantation (SDPL). From the start of the year to end-November 2018, KLK and GenP have outperformed the KLCI on a relative basis in spite of the 26.8% plunge in CPO prices. KLK and GenP have outperformed the KLCI by one to 4 percentage points on a six-month basis. In our coverage, KLK has the highest foreign shareholding of 17.71%, followed by IOI with about 9.8% while SDPL’s foreign shareholding was 12.31% as at end-October 2018..

Reducing 2019F CPO price assumption from RM2,500/tonne to RM2,300/tonne (2018E spot price: RM2,294/tonne). We have also revised the operating profit margin of plantation companies downwards as costs of fertiliser, transportation and wages are expected to increase in 2019F.

Will CPO prices improve or will there be a prolonged slump? We believe that while CPO prices may have bottomed, they may also be in the doldrums for some time due to a lack of catalysts. CPO prices hovered between RM2,200/tonne and RM2,400/tonne for two years from 3Q2014 to 3Q2016 after reaching a low of RM1,942/tonne in September 2014. On the flipside, there will be a quick recovery in CPO price if there is a supply shock. El Nino was the kicker that boosted CPO prices in 3Q2016.

What has changed in the industry? A few things. Instead of supporting CPO prices, the B20 biodiesel policy in Indonesia has done the opposite. B20 has exacerbated the glut in palm oil in Kalimantan. The implementation of the B20 biodiesel policy in Indonesia has caused logistics problems as barges or vessels were used to transport biodiesel instead of CPO. If companies do not increase the number of barges or vessels and at the same time, Indonesia implements the B25 or B30 biodiesel policy, the glut in palm oil may worsen. This is unless industry production of CPO drops drastically.

There may be incentive for Indonesia to delay the implementation of B25 or B30 if crude oil prices continue to decline and the Indonesian rupiah continues to appreciate. Crude oil price has fallen by 28.8% from its peak and it is in a bear market currently. Also, the Indonesian rupiah has reversed its decline against the USD. Since reaching a low of US$1.00/ Rp15,238 on 9 October, the rupiah has appreciated by 4.5% against the USD. Recall that Indonesia accelerated the implementation of B20 biodiesel in 2H2018 as the fall in the rupiah made the cost of importing diesel expensive.

Second, there is concern that the devaluation of the Chinese yuan and Indian rupee may affect the demand for palm oil. Also, buyers may postpone purchases in anticipation of CPO prices becoming cheaper. In addition, there is a risk of a default by Indian buyers, which usually takes place when palm prices are weak. India and China accounted for 23.8% of Malaysia’s palm exports and 36.6% of Indonesia’s palm exports in 2017.

Who will make the highest profit per tonne based on average CPO price of RM2,300/tonne for 2019F?We estimate that GenP and IOI will make the largest profit (after depreciation, overheads and interest) of RM600/tonne each. This is based on an average CPO price of RM2,300/tonne and all-in production costs of RM1,700/tonne (Malaysia and Indonesia) each.

FGV Holdings and THP have the lowest profit per tonne of RM42 and RM29 respectively. FGV’s all-in production cost per tonne is high partly because of cash payments to FELDA Group for the lease of the oil palm estates.

We estimate KLK’s profit to be RM383/tonne based on an all-in production cost of about RM1,917/tonne. KLK’s all-in production cost per tonne is high as depreciation expense is expected to increase due to the implementation of a new accounting standard. KLK is the last plantation company to implement the accounting standard.

SDPL’s profit is estimated to be RM550/tonne based on an all-in production cost of RM1,750/tonne. Among the smaller-caps, TSH Resources is estimated to record a profit of about RM62/tonne while IJM Plantations’ profit is estimated to be RM400/tonne based on their all-in production costs of RM2,238/tonne and RM1,900/tonne respectively.